For individuals and companies, categorizing income as ordinary instead of as a long-term capital gain may change the effective tax rate for that income. For most business types and individual taxpayers, the tax rate applied to long-term capital gains is lower than the rate used for ordinary income. Ordinary income is any income earned through operations. As with individuals, business income obtained from the disposition of a capital asset held for more than a year is taxed at the lower long-term capital gains rate.
The IRS defines business income as derived from the sale of products or services. The definition explicitly includes fees received by a person for the regular practice of a profession and rent received by a person in the real estate business. Further, the IRS notes that if you receive income in the form of property or services, you must include the fair market value of the property or services received as income.
For example, if you own a business that sells astrology readings, your ordinary income includes the fees you charge clients for the information you provide. You may also have income from selling written material or related products to your clients and even from affiliate marketing relationships. However, your business can reduce the amount of taxable ordinary business income by subtracting the cost of business expenses. For example, if you deliver the readings in an office, you may deduct the cost of maintaining the space. Other examples include advertising and the cost to acquire the items you sell. The remainder is ordinary business income.
However, if you own a building and use it in your business, that is a capital asset. If you hold it for more than a year and sell it for more than your basis, that is a capital gain. But, of course, if you sell the capital asset for less than your basis, that is a capital loss.
Qualified Business Income (QBI) refers to a deduction that the Tax Cuts and Jobs Act (TCJA) created. The QBI deduction allows owners of pass-through business entities to deduct twenty percent of their qualified business income from the amount on which they pay taxes. It’s important to note that this deduction sunsets at the end of 2025. In the meantime, it applies to business operations, not property being held for appreciation.
Furthermore, the QBI deduction in the TCJA phases out income derived from specific service-related businesses, including consulting, financial services, performing arts, athletics, and legal and health professionals. So, if the astrology consulting business provides income above the threshold, it might be excluded from eligibility.
For most business structures, ordinary business income is a catchall term for the money gained from day-to-day operations. The income that the owner pays taxes on is the net income, calculated by deducting business expenses from business income.